The 99 percent and the problem of societal underinvestment

December 27, 2011

The 99 percent and the problem of societal underinvestment

December 27, 2011

I think it is hard for active market participants to believe but most people don’t like to take on financial risk. We have previously argued that the vast majority, like 99%, of people don’t want to actively trade. The core finding of behavioral finance is that humans are loss averse. That is we experience the pain of loss more acutely than we experience the joy of gains. It is our supposition that in order to induce individuals to take on financial risk they need to feel tricked into it.

This happens in a couple of ways. The first, most obvious, way happens in the course of market booms, i.e. bubbles. When financial markets enter into an extended period of gains without much in the way of losses it makes the markets seem less risky than they actually are. Anyone who experienced the Internet bubble saw how the relentless upward march in the stock market pulled in investors into the market who had not previously participated.

Most people investing in the midst of a bubble likely had a less than positive outcomes. Some like Daniel Gross argue that from a societal perspective the investment, or overinvestment, that occurs in the midst of a bubble actually has some benefits for the economy as a whole. The current wave of Internet startups from Facebook, Linked or Groupon would not have been possible were it not for the malinvestment that occurred a decade prior.

Bubbles are most often the exception for financial markets. How is it that in the normal course of the economy do we induce reluctant, risk-averse individuals to take on financial risk? Steve Randy Waldman has a must-read piece up that discusses this very topic. Waldman in discussing the increasingly complexity of the financial system talks about how complexity rather than being a bug is actually a feature of the modern financial system.

For a society to prosper it has to mobilize the collective investment of its citizens. Absent that it ends up at a suboptimal equilibrium unable to achieve high and sustainable levels of economic growth. Waldman writes:

This is the business of banking. Opacity is not something that can be reformed away, because it is essential to banks’ economic function of mobilizing the risk-bearing capacity of people who, if fully informed, wouldn’t bear the risk. Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper. Insufficient economic risks are taken to sustain growth and development. You can have opacity and an industrial economy, or you can have transparency and herd goats.

The problem as Waldman sees it is that this sort of financial system also makes possible the crony capitalism we now seem to be bumping up against on a continuous basis. However the banking system is not the only way in which the financial system motivates risk taking. The asset management industry is another, likely less fraudulent, way in which individuals take on financial risk. The development and growth of transparent collective investment vehicles like mutual funds and exchange traded funds is the predominant way in which individuals invest their hard earned cash.

If you ask most individual investors about the actual inner workings of their funds they would likely be at a loss for what custodian their funds are housed or what firm conducts the annual audits. We take these things for granted. When the system goes wrong like it has done when money market mutual funds faced breaking the buck or the case of MF Global it makes investors anxious about the system as a whole and curtails their willingness to take on risk.

It isn’t the job of the government to make investment decisions for its citizens. Its job is to make the process of risk taking transparent enough that we collectively invest enough to sustainably grow the economy. Sometimes the wheels come off like it did in a big way in the case of the financial crisis of 2008-09 or in a small way in the case of MF Global. Hangovers after a period of malinvestment are inevitable. What is not inevitable is individuals losing faith in the financial system as a whole. A truly sustainable recovery will not come along until individuals once again feel, right or wrong, that financial intermediaries are working for them and not the other way around.

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